Ebbers to Scrushy to Skilling and Lay

JURIST Guest Columnist Douglas Branson of the University of Pittsburgh School of Law says that defense lawyers in recent corporate fraud cases are not seeking to introduce reasonable doubts that might lead a jury to acquit their clients, but in the absence of much direct evidence are rather offering competing versions of events that threaten to reduce verdicts to a flip of the coin...

"Evers to Tinker to Chance" is the paradigmatic baseball double play combination. In similar fashion, "Ebbers to Scrushy to Skilling and Lay" has become the mantra of prosecutors seeking conviction of corporate CEOs for business crimes.

In the WorldCom criminal trial, prosecutors obtained a jury verdict of securities fraud. The court sentenced Bernie Ebbers to 25 years. The jury had found that Ebbers knew about, and failed to disclose, the capitalization of line costs (local telephone company charges) and the poaching of line cost accruals by WorldCom CFO Scott Sullivan, resulting in what has been reported as an $11 billion fraud. By so doing, Sullivan made costs seem much lower than they were, masking from view losses and a deteriorating financial situation at WorldCom, then the U.S.'s 35th largest corporation by revenues.

As the expert witness for some of the independent WorldCom directors in the civil lawsuit, I received daily transcripts of the Ebbers criminal trial, on an almost real time basis. I thought that the prosecution produced little, if any, other direct evidence that Ebbers knew about the fraudulent accounting. At the time, I remarked "they haven't laid a glove (boxing, not baseball) on him yet." The case came down to Scott Sullivan's versus Bernie Ebbers's word. The jury believed Sullivan, and afterwards commented that "he (Ebbers) must have known - he was the CEO."

HealthSouth, the company Richard Scrushy founded, provides physical and medical therapy through shopping center and strip mall outlets, close to where patients live. The Selma, Alabama "good ole boy," who had begun as a respiration therapist, grew the company into a publicly held darling of Wall Street. In the meantime, he became a benefactor of the Birmingham, Alabama community, which named a street (Scrushy Boulevard) after him. The comings and goings of his rock band and of Scrushy's commutes to his Lake Alexandria weekend home (by seaplane) became fashion news for many Alabamians.

Then Medicare cut its reimbursement rates for the types of care that HealthSouth provided. The allegations were that Scrushy directed subordinates "to find the dirt to fill the holes" so that HealthSouth could continue to meet or exceed Wall Street projections. Five HealthSouth CFOs testified that CEO Scrushy had directed them to and knew about efforts to cook the books. Yet a Birmingham jury acquitted Richard Scrushy. The jurors evidently rejected the "he's the CEO - he must have known" inference, along with the live testimony.

Why Ebbers but not Scrushy? It seems easy: New York versus Alabama. As evidence of this, observe how Scrushy greased the rails. His son-in-law had a daily television talk show devoted to the trial on local tv. Scrushy's lawyers would show up as invited guests. Scrushy often attended trial with a large and well worn leather bible in hand, visible to a jury with six African Americans, some of whom, along with others, may have been religious. During the trial, Scrushy preached at services in a Birmingham church, a fact that well may have percolated through to the jury. Those extra's could not have been pulled off in New York, even if a defendant had been willing to pay the price.

Both trials, however, seem like a fight you may have had with your brother or sister: "is too," "is not," "is too, "is not," and so on and so on. There was little direct evidence tying the defendants to the crimes charged except the word of their subordinates, "my word against his." Is there a hypothesis here?

Although the sample is very small (two cases), can it be that, in "my word against yours" cases, beyond reasonable doubt, as a measure of the evidentiary showing a prosecutor must make, goes out the window? Just like all of us, juries love to decide between two competing stories, one of innocence and one of wrongdoing. If my word against his case is 50-50, or 60-40, or even 70-30 in favor of wrongdoing, under the beyond a reasonable doubt formula, a jury should still decide in favor of innocence, or at least "not proven." But they don't seem to. Juries seem to like making a decision, either way, against two competing versions of events.

In a current trial, now ongoing in Houston, federal prosecutors are attempting to prove that in the year or so leading up to the demise of Enron, then the U.S. 7th largest corporation, according to market capitalization, CEO Jeffrey Skilling and CEO-Chairman-CEO again Ken Lay committed securities fraud. The gist of the charges is that Skilling and Lay permitted the CFO, Andrew Fastow, to act as general partner of limited partnerships (LJM1 and LJM2) that provided seed capital to various special purpose entities (SPEs) so that Enron could move assets, and related debt, into the SPEs and thus off Enron's books. Enron could thus borrow more and keep its debt rating and stock price high, as the off books movements (the "asset lite" business plan) and the SPEs took on much of the corporate debt. The beginning of the end came when accountants Arthur Andersen made a belated call that Enron had to more $1.3 billion in debt back onto its (Enron's) own books. Fastow made $46 million by acting as general partner and he violated many of the rules regarding SPEs, without disclosing that he had done so.

Once again the lawyers seem also to be trying this case as a "my word against his," or an "is too, is not," case. The prosecutors have elicited from witnesses statements that Skilling and Lay seemed to have known what went on, masked not only a deteriorating situation but a house of cards from analysts and investors, and did nothing to correct the problems, even after whistleblowers apprised them of accounting shenanigans.

As one might predict, lead defense attorney Daniel Petrocelli takes the exact opposite view. Everything that took place at Enron, according to Petrocelli, was legal. Should they obtain a conviction, the prosecutors, along with government's approach, will cause every business person to act in a more conservative fashion and to abjure taking risks if any material chance exists that losses might ensue.

This seems to be deja vue all over again, to quote Yogi Berra. Who do you believe? If it is close, flip a coin. It seems as though the defense approach leaves too much room for proof beyond a reasonable doubt to fly out the window. The defendants will benefit only if the jury believes their story.

A far better first year law student approach is to escape the "is too, is not" cycle by replying "actually, this is what it is" or this is "what it might be." Such an approach shifts the burden back to the prosecutor to show by rebuttal that it isn't the case after all. It also re-introduces the "beyond a reasonable doubt" standard into the case. The defense says "here is a reasonable doubt," or "here is a reasonable doubt and then some."

Within Enron, the board of directors (or more accurately the board committees, as Skilling and Lay were both on the 16 person board) held the thread that would have unraveled the fabric, revealing the wrongdoing. Not just once but twice Fastow asked for permission to do what he eventually did. Both times, Skilling and Lay, or others with Skilling's and Lay's approval, made the right call. They told Fastow that Enron had a written code of ethics, well posted and applicable to all employees. That code of ethics contained a section on conflicts of interest. If Fastow did what he desired to do, his actions would constitute forbidden conflicts of interest and violations of those code provisions.

Skilling, or Lay, or both, then sent Andrew Fastow to the board of directors Audit Committee which had charge of waivers of conflicts of interest. They would not have done so if they had anything to hide or if they did not wish Fastow's limited partnerships to see the full light of day.

Fastow duly went to the Audit Committee of the board of directors, comprised exclusively of independent directors (no insiders such as Skilling or Lay or their subordinates). The committee hesitated but then granted the requested waivers on not only one but two occasions. The committee did so reluctantly, however, as it appended to the waivers prolix procedures monitoring what Fastow was to do and not to do, as well as the amount of compensation he was to receive.

The difficulty is that the Enron Audit Committee assigned implementation to the Finance Committee of the board of directors. But they never informed the Finance Committee. Thus there was no followup. Monitoring and other followup either might have checked Fastow in his actions, or sounded the alarm when he began to take excessive compensation and otherwise bend the rules.

In August, 2001, Andrew Skilling resigned as CEO after only 6 months in office. In April, 2006, he testified that he was "hurt" when not a single board member expressed misgivings about Skilling's premature resignation. Perhaps the directors all thought Skilling to be arrogant and condescending, which seems to have been one view which prevailed at the time. Just as likely, the directors may have known that they, or key players among them, had dropped the ball. They felt sheepish about a situation of which they had an inkling at least and which could put Jeffrey Skilling and Ken Lay in a very bad light, not to say Enron"s employees and shareholders as well.

Much of modern corporate governance is conducted by committees of directors (audit, governance and nominating, compensation, finance, etc.) rather than the full board of directors itself. Few, however, have given thought to the need for committees to network, coordinating the work assigned to them and planning for the future. One schematic assigns to the chair person of the board, previously regarded largely as a ceremonial or honorary position, the task but the proposal has not attracted attention. Many observers do believe that what happened at Enron, an important matter "falling between the cracks, is more widespread than it should be, a shortcoming that receives little attention but an important one, given the way in which modern corporations police themselves.

The facts at Enron are known. They could be elicited from a director or two who had been on the Audit Committee. The U.S. Senate Report, "The Role of the Board of Directors in the Collapse of Enron," furnishes every necessary detail. The Audit Committee, not Jeffrey Skilling or Ken Lay, had in hand the thread which, if pulled, would have caused the whole thing to unravel.

It seems as though lawyering in these cases (Ebbers's, Scrushy's, Skilling's and Lay's) has been caught up in macho posturing. It is not only "my word against his," and "is too, is not," but "mano a mano." The defense team will not seek to jump shift, introducing a reasonable doubt into the case. They will persist in merely joining issue with the prosecution, butting heads, leaving the jury to decide the case, once again, by a flip of a coin.

Douglas M. Branson is W. Edward Sell Professor of Business Law at the University of Pittsburgh School of Law
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